John Hussman Asks "What Is Different This Time?"

Investors who believe that history has lessons to teach should take our present concerns with significant weight, but should also recognize that tendencies that repeatedly prove reliable over complete market cycles are sometimes defied over portions of those cycles. Meanwhile, investors who are convinced that this time is different can ignore what follows. The primary reason not to listen to a word of it is that similar concerns, particularly since late-2011, have been followed by yet further market gains. If one places full weight on this recent period, and no weight on history, it follows that stocks can only advance forever.

What seems different this time, enough to revive the conclusion that “this time is different,” is faith in the Federal Reserve’s policy of quantitative easing. Though quantitative easing has no mechanistic relationship to stock prices except to make low-risk assets psychologically uncomfortable to hold, investors place far more certainty in the effectiveness of QE than can be demonstrated by either theory or evidence. The argument essentially reduces to a claim that QE makes stocks go up because “it just does.” We doubt that the perception that an easy Fed can hold stock prices up will be any more durable in the next couple of years than it was in the 2000-2002 decline or the 2007-2009 decline – both periods of persistent and aggressive Fed easing. But QE is novel, and like the internet bubble, novelty feeds imagination. Most of what investors believe about QE is imaginative.

As Ray Dalio of Bridgwater recently observed,

“The dilemma the Fed faces now is that the tools currently at its disposal are pretty much used up. We think the question around the effectiveness of QE (and not the tapering, which gets all the headlines) is the big deal. In other words, we’re not worried about whether the Fed is going to hit or release the gas pedal, we’re worried about whether there’s much gas left in the tank and what will happen if there isn’t.”

While we can make our case on the basis of fact, theory, data, history, and sometimes just basic arithmetic, what we can’t do – and haven’t done well – is to disabuse perceptions. Beliefs are what they are, and are only as malleable as the minds that hold them. Like the nearly religious belief in the technology bubble, the dot-com boom, the housing bubble, and countless other bubbles across history, people are going to believe what they believe here until reality catches up in the most unpleasant way. The resilience of the market late in a bubble is part of the reason investors keep holding and hoping all the way down. In this market cycle, as in all market cycles, few investors will be able to unload their holdings to the last of the greater fools just after the market’s peak. Instead, most investors will hold all the way down, because even the initial decline will provoke the question “how much lower could it go?” It has always been that way.

The problem with bubbles is that they force one to decide whether to look like an idiot before the peak, or an idiot after the peak. There’s no calling the top, and most of the signals that have been most historically useful for that purpose have been blaring red since late-2011.

As a result, the Shiller P/E (the S&P 500 divided by the 10-year average of inflation-adjusted earnings) is now above 25, a level that prior to the late-1990’s bubble was seen only in the three weeks prior to the 1929 peak. Meanwhile, the price/revenue ratio of the S&P 500 is now double its pre-bubble norm, as is the ratio of stock market capitalization to GDP. Indeed, the median price/revenue ratio of the S&P 500 is actually above the 2000 peak – largely because small cap stocks were much more reasonably priced in 2000 than they are today (not that those better relative valuations prevented wicked losses in small caps during the 2000-2002 decline).

Despite the unusually extended period of speculation as a result of faith in quantitative easing, I continue to believe that normal historical regularities will exert themselves with a vengeance over the completion of this market cycle. Importantly, the market has now re-established the most hostile overvalued, overbought, overbullish syndrome we identify. Outside of 2013, we’ve observed this syndrome at only 6 other points in history: August 1929 (followed by the 85% market decline of the Great Depression), November 1972 (followed by a market plunge in excess of 50%), August 1987 (followed by a market crash in excess of 30%), March 2000 (followed by a market plunge in excess of 50%), May 2007 (followed by a market plunge in excess of 50%), and January 2011 (followed by a market decline limited to just under 20% as a result of central bank intervention).

These concerns are easily ignored since we also observed them at lower levels this year, both in February (see A Reluctant Bear’s Guide to the Universe) and in May. Still, the fact is that this syndrome of overvalued, overbought, overbullish, rising-yield conditions has emerged near the most significant market peaks – and preceded the most severe market declines – in history:

1. S&P 500 Index overvalued, with the Shiller P/E (S&P 500 divided by the 10-year average of inflation-adjusted earnings) greater than 18. The present multiple is actually 25.

2. S&P 500 Index overbought, with the index more than 7% above its 52-week smoothing, at least 50% above its 4-year low, and within 3% of its upper Bollinger bands (2 standard deviations above the 20-period moving average) at daily, weekly, and monthly resolutions. Presently, the S&P 500 is either at or slightly through each of those bands.

3. Investor sentiment overbullish (Investors Intelligence), with the 2-week average of advisory bulls greater than 52% and bearishness below 28%. The most recent weekly figures were 55.2% vs. 15.6%. The sentiment figures we use for 1929 are imputed using the extent and volatility of prior market movements, which explains a significant amount of variation in investor sentiment over time.

The blue bars in the chart below depict the complete set of instances since 1970 when these conditions have been observed.

Our investment approach remains to align our investment outlook with the prospective market return/risk profile that we estimate on the basis of prevailing conditions at each point in time. On that basis, the outlook is hard-defensive, and any other stance is essentially speculative. Such speculation is fine with insignificant risk-limited positions (such as call options), but I strongly believe that investors with a horizon of less than 5-7 years should limit their exposure to equities. At this horizon, even “buy-and-hold” strategies in stocks are inappropriate except for a small fraction of assets. In general, the appropriate rule for setting investment exposure for passive investors is to align the duration of the asset portfolio with the duration of expected liabilities. At a 2% dividend yield on the S&P 500, equities are effectively instruments with 50-year duration. That means that even stock holdings amounting to 10% of assets exhaust a 5-year duration. For most investors, a material exposure to equities requires a very long investment horizon and a wholly passive view about market prospects.

Again, our approach is to align our outlook with the prospective return/risk profile we estimate at each point in time. That places us in a defensive stance. Still, we’re quite aware of the tendency for investors to capitulate to seemingly relentless speculation at the very peak of bull markets, and saw it happen in 2000 and 2007 despite our arguments for caution.

As something of an inoculation against this tendency, the chart below presents what we estimate as the most “optimistic” pre-crash scenario for stocks. Though I don’t believe that markets follow math, it’s striking how closely market action in recent years has followed a “log-periodic bubble” as described by Didier Sornette (see Increasingly Immediate Impulses to Buy the Dip).

A log periodic pattern is essentially one where troughs occur at increasingly frequent and increasingly shallow intervals. As Sornette has demonstrated across numerous bubbles over history in a broad variety of asset classes, adjacent troughs (say T1, T2, T3, etc) are often related to the crash date (the “finite-time singularity” Tc) by a constant ratio: (Tc-T1)/(Tc-T2) = (Tc-T2)/(Tc-T3) and so forth, with the result that successive troughs come closer and closer in time until the final blowoff occurs.

Frankly, I thought that this pattern was nearly exhausted in April or May of this year. But here we are. What’s important here is that the only way to extend that finite-time singularity is for the advance to become even more vertical and for periodic fluctuations to become even more closely spaced. That’s exactly what has happened, and the fidelity to the log-periodic pattern is almost creepy. At this point, the only way to extend the singularity beyond the present date is to envision a nearly vertical pre-crash blowoff.

So let’s do that. Not because we should expect it, and surely not because we should rely on it, but because we should guard against it by envisioning the most “optimistic” (and equivalently, the worst case) scenario. So with the essential caveat that we should neither expect, rely or be shocked by a further blowoff, the following chart depicts the market action that would be consistent with a Sornette bubble with the latest “finite time singularity” that is consistent with market action since 2010.

To be very clear: conditions already allow a finite-time singularity at present, the scenario depicted above is the most extreme case, it should not be expected or relied on, but we should also not be shocked or dismayed if it occurs.

Just a final note, which may or may not prove relevant in the weeks ahead: in August 2008, just before the market collapsed (see Nervous Bunny), I noted that increasing volatility of the market at 10-minute intervals was one of the more ominous features of market action. This sort of accelerating volatility at micro-intervals is closely related to log-periodicity, and occurs in a variety of contexts where there’s a “phase transition” from one state to another. Spin a quarter on the table and watch it closely. You’ll notice that between the point where it spins smoothly and the point it falls flat, it will start vibrating uncontrollably at increasingly rapid frequency. That’s a phase transition. Again, I don’t really believe that markets follow math to any great degree, but there are enough historical examples of log-periodic behavior and phase-transitions in market action that it helps to recognize these regularities when they emerge.

It's interesting that the most “optimistic” scenario (i.e., the Sornette “log-periodic bubble” becoming vertical) is simultaneously the worst case scenario. That's because ALL BUBBLES EVENTUALLY POP. As Hussman notes, at this point, "the only way to extend the singularity beyond the present date is to envision a nearly vertical pre-crash blowoff." We are currently witnessing pre-bubble crash hysteria/mania/euphoria that has been experienced only twice before: the 1929 bubble and the 1999-2000 Internet Bubble. But if the S&P continues to go vertical, we will soon find ourselves in completely uncharted bubble territory.

During the Internet Bubble the Fed eventually raised interest rates to counteract the bubble. But today, the Fed is keeping rates at zero whilst simultaneously implementing QE.

So, the question we must ask is "why is the Fed intentionally blowing bubbles?"

"Every day I run around trying to find something to invest in. Sorry to say that I didn't find anything today."

That means that you're not able to identify value.

If one goes by the measure as it pertains to "modern" investing for profit then yes, no surprise. But, if you're investing as measured in the things that matter most then there's ample to invest in- one only need alter one's perspective on what "profits/'to profit'" means.

Every day I continue to invest my time and energy improving my land and farm. And, to really fuck with people's heads, I have no heirs to leave it to (well, except... and, well, my wife has kids, but the're in another country). I do it because I feel that I owe it to a future generation that will find itself in a fucked up enough position: it's an offering hoping that I don't get prematurely snuffed out by angry youth.

Though your actions are admirable, I don't see the connection between what you do and what it has to do with a future generation. Snuffed out? As in, I'm taking your land motherfucker? Are you grooming youngsters to take over and let you live in a cozy little place down by the creek?

Making a million is an achievement going from 100 million to 110 is inevitable... was their mantra. A never ending gravy train.

When the law of diminishing returns becomes new mantra and that "profit" is nothing but leveraged debt opium on which you are addicted, you are on that train and you don't want to admit it.

"I never had sex with that train ticket! I didn't even know it existed so how can you accuse me of it? I tell you its all your hallucination. We are going to the moon on WS levitation and we are on a rocket not on a train. I swear it!"

"But QE is novel, and like the internet bubble, novelty feeds imagination. Most of what investors believe about QE is imaginative."

I believe QE is serving to monetize the tremedous federal deficit so that government can keep spending to offset the PERMANENT (not cyclical) reduction in real output that took place in 08-09. I bet I'm not imagining that.

Exactly. The history of QE's is that they're deflationary. In other words "sure you get the timing right" (prior to collapse begin massive easing) but the sequential ism must be followed through (taper/normalization.) QE "addiction" for lack of a better term causes massive "demand dysfunction" leading to massive amounts of "stranded capital" (housing?!!!) that just sits around unused. So suddenly your not confronted with a "gold shortage" but a liquidity shortfall...instant oblivion if not met. "We'll just print liquidity into existence"? Really? How so? "By more QE"? That seems like the exactly wrong thing to do.

What is different this time is that "it" is global. Human nature being what it is with the fed needing to keep interest rates low to feed an ever growing public sector.

If daily sustainable numbers of "things" were growing, I doubt anyone would care how much debt was being extrapolated at what interest rate because everyone would steadily be getting moar, but that isn't the case that has been for the past 75-150 years of persistent economic growth.

It takes time to adjust to a new paradigm and unwind 65 years of(non U.S. central bank) U.S. debt accumulation but since the world has to, it will.

Though quantitative easing has no mechanistic relationship to stock prices except to make low-risk assets psychologically uncomfortable to hold, investors place far more certainty in the effectiveness of QE than can be demonstrated by either theory or evidence.

A plot of the Fed's balance sheet against the S&P 500 since the Mar 2009 bottom has a correlation coefficient of over 0.93. There has to be a mechanistic relationship even if it is hidden from ordinary investors. So what could that relationship be? QE causes aggregate bank deposits to increase by an identical dollar amount. I have seen speculation on ZH that banks are able to use those deposits as collateral in shadow banking transactions without the fact appearing on any official balance sheet. If this is true, then there is a direct causal mechanism for each $ of QE to increase the S&P 500 by the observed value of $3. The BTFATH can then continue until the shadow banking system itself implodes, the collateral chains are broken, and all shadow debts become due and payable. And if that happens, the Fed Chair is in the position of Adric on an old Dr Who episode, where he is holding bare wires from the destroyed control panel of a starship that is barreling toward Earth at warp speed 65 million years ago, and killed the dinosaurs. I can just imagine Janet Yellen in that position, screaming her head off. No wonder The Bernank is getting the hell out of Dodge.